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Interest Rates

Practice Questions

Problem 4.8.

The cash prices of six-month and one-year Treasury bills are 94.0 and 89.0. A 1.5-year bond

that will pay coupons of $4 every six months currently sells for $94.84. A two-year bond that

will pay coupons of $5 every six months currently sells for $97.12. Calculate the six-month,

one-year, 1.5-year, and two-year zero rates.

The 6-month Treasury bill provides a return of 6 / 94 = 6.383% in six months. This is

2 �6.383 = 12.766% per annum with semiannual compounding or 2 ln(1.06383) = 12.38%

per annum with continuous compounding. The 12-month rate is 11 / 89 = 12.360% with

annual compounding or ln(1.1236) = 11.65% with continuous compounding.

For the 1 12 year bond we must have

4e -0.1238�0.5 + 4e -0.1165�1 + 104e-1.5 R = 94.84

where R is the 1 12 year zero rate. It follows that

3.76 + 3.56 + 104e -1.5 R = 94.84

e -1.5 R = 0.8415

R = 0.115

or 11.5%. For the 2-year bond we must have

5e -0.1238�0.5 + 5e -0.1165�1 + 5e -0.115�1.5 + 105e -2 R = 97.12

where R is the 2-year zero rate. It follows that

e -2 R = 0.7977

R = 0.113

or 11.3%.

Problem 4.9.

What rate of interest with continuous compounding is equivalent to 15% per annum with

monthly compounding?

12

� 0.15 �

eR = �

1+ �

� 12 �

i.e.,

� 0.15 �

R = 12 ln �

1+ �

� 12 �

= 0.1491

The rate of interest is therefore 14.91% per annum.

Problem 4.10.

A deposit account pays 12% per annum with continuous compounding, but interest is

actually paid quarterly. How much interest will be paid each quarter on a $10,000 deposit?

4

� R�

e0.12 = �1+ �

� 4�

or

R = 4(e0.03 - 1) = 0.1218

0.1218

10, 000 � = 304.55

4

or $304.55.

Problem 4.11.

Suppose that 6-month, 12-month, 18-month, 24-month, and 30-month zero rates are 4%,

4.2%, 4.4%, 4.6%, and 4.8% per annum with continuous compounding respectively. Estimate

the cash price of a bond with a face value of 100 that will mature in 30 months and pays a

coupon of 4% per annum semiannually.

The bond pays $2 in 6, 12, 18, and 24 months, and $102 in 30 months. The cash price is

2e -0.04�0.5 + 2e -0.042�1.0 + 2e -0.044�1.5 + 2e-0.046�2 + 102e-0.048�2.5 = 98.04

Problem 4.12.

A three-year bond provides a coupon of 8% semiannually and has a cash price of 104. What

is the bond’s yield?

The bond pays $4 in 6, 12, 18, 24, and 30 months, and $104 in 36 months. The bond yield is

the value of y that solves

4e-0.5 y + 4e-1.0 y + 4e-1.5 y + 4e-2.0 y + 4e -2.5 y + 104e-3.0 y = 104

Using the Goal Seek or Solver tool in Excel y = 0.06407 or 6.407%.

Problem 4.13.

Suppose that the 6-month, 12-month, 18-month, and 24-month zero rates are 5%, 6%, 6.5%,

and 7% respectively. What is the two-year par yield?

A = e-0.05�0.5 + e-0.06�1.0 + e -0.065�1.5 + e-0.07�2.0 = 3.6935

The formula in the text gives the par yield as

(100 - 100 0.8694) 2

= 7.0741

3.6935

To verify that this is correct we calculate the value of a bond that pays a coupon of 7.0741%

per year (that is 3.5370 every six months). The value is

3.537e -0.050.5 + 3.537e -0.061.0 + 3.537e -0.0651.5 + 103.537e -0.072.0 = 100

Problem 4.14.

Suppose that risk-free zero interest rates with continuous compounding are as follows:

1 2.0

2 3.0

3 3.7

4 4.2

5 4.5

Calculate forward interest rates for the second, third, fourth, and fifth years.

Year 2: 4.0%

Year 3: 5.1%

Year 4: 5.7%

Year 5: 5.7%

Problem 4.15.

Use the risk-free rates in Problem 4.14 to value an FRA where you will pay 5% for the third

year and receive LIBOR on $1 million. The forward LIBOR rate (annually compounded) for

the third year is 5.5%.

The 3-year risk-free interest rate is 3.7% with continuous compounding. From equation

(4.10), the value of the FRA is therefore

[1, 000, 000 �(0.055 - 0.05) �1]e -0.037�3 = 4, 474.69

or $4,474.69.

Problem 4.16.

A 10-year, 8% Treasury coupon bond currently sells for $90. A 10-year, 4% coupon Treasury

bond currently sells for $80. What is the 10-year zero rate? (Hint: Consider taking a long

position in two of the 4% coupon bonds and a short position in one of the 8% coupon bonds.)

Taking a long position in two of the 4% coupon bonds and a short position in one of the 8%

coupon bonds leads to the following cash flows

Year 0: 90 − 2×80 = −70

Year 10: 200 – 100 = 100

because the coupons cancel out. $100 in 10 years time is equivalent to $70 today. The 10-year

rate, R, (continuously compounded) is therefore given by

100 = 70e10 R

The rate is

1 100

ln = 0.0357

10 70

or 3.57% per annum.

Problem 4.17.

Explain carefully why liquidity preference theory is consistent with the observation that the

term structure of interest rates tends to be upward sloping more often than it is downward

sloping.

If long-term rates were simply a reflection of expected future short-term rates, we would

expect the term structure to be downward sloping as often as it is upward sloping. (This is

based on the assumption that half of the time investors expect rates to increase and half of the

time investors expect rates to decrease). Liquidity preference theory argues that long term

rates are high relative to expected future short-term rates. This means that the term structure

should be upward sloping more often than it is downward sloping.

Problem 4.18.

“When the zero curve is upward sloping, the zero rate for a particular maturity is greater

than the par yield for that maturity. When the zero curve is downward sloping the reverse is

true.” Explain why this is so.

The par yield is the yield on a coupon-bearing bond. The zero rate is the yield on a zero-

coupon bond. When the yield curve is upward sloping, the yield on an N-year coupon-bearing

bond is less than the yield on an N-year zero-coupon bond. This is because the coupons are

discounted at a lower rate than the N-year rate and drag the yield down below this rate.

Similarly, when the yield curve is downward sloping, the yield on an N-year coupon bearing

bond is higher than the yield on an N-year zero-coupon bond.

Problem 4.19.

Why are U.S. Treasury rates significantly lower than other rates that are close to risk free?

1. The amount of capital a bank is required to hold to support an investment in Treasury bills

and bonds is zero whereas capital is required to support a similar investment in other

very-low-risk instruments.

2. In the United States, Treasury instruments are given a favorable tax treatment compared

with most other fixed-income investments because they are not taxed at the state level.

Problem 4.20.

Why does a loan in the repo market involve very little credit risk?

A repo is a contract where an investment dealer who owns securities agrees to sell them to

another company now and buy them back later at a slightly higher price. The other company

is providing a loan to the investment dealer. This loan involves very little credit risk. If the

borrower does not honor the agreement, the lending company simply keeps the securities. If

the lending company does not keep to its side of the agreement, the original owner of the

securities keeps the cash.

Problem 4.21.

Explain why an FRA is equivalent to the exchange of a floating rate of interest for a fixed

rate of interest?

A FRA is an agreement that a certain specified interest rate, RK , will apply to a certain

principal, L, for a certain specified future time period. Suppose that the rate observed in the

market for the future time period at the beginning of the time period proves to be RM . If the

FRA is an agreement that RK will apply when the principal is invested, the holder of the FRA

can borrow the principal at RM and then invest it at RK . The net cash flow at the end of the

period is then an inflow of RK L and an outflow of RM L . If the FRA is an agreement that RK

will apply when the principal is borrowed, the holder of the FRA can invest the borrowed

principal at RM . The net cash flow at the end of the period is then an inflow of RM L and an

outflow of RK L . In either case, we see that the FRA involves the exchange of a fixed rate of

interest on the principal of L for a floating rate of interest on the principal.

Problem 4.22.

Explain how a repo agreement works and why it involves very little risk for the lender.

The borrower transfers to the lender ownership of securities which have a value

approximately equal to the amount borrowed and agrees to buy them back for the amount

borrowed plus accrued interest at the end of the life of the loan. If the borrower defaults, the

lender keeps the securities. Note that the securities should not have a value significantly more

or less than the amount borrowed. Otherwise the risk of a loss if the borrower or the lender

does not live up to its obligations may be unacceptable.

Further Questions

Problem 4.23

When compounded annually an interest rate is 11%. What is the rate when expressed with (a)

semiannual compounding, (b) quarterly compounding, (c) monthly compounding, (d) weekly

compounding, and (e) daily compounding.

We must solve 1.11=(1+R/n)n where R is the required rate and the number of times per year

the rate is compounded. The answers are a) 10.71%, b) 10.57%, c) 10.48%, d) 10.45%, e)

10.44%

Problem 4.24

The following table gives Treasury zero rates and cash flows on a Treasury bond:

0.5 2.0% $20

1.0 2.3% $20

1.5 2.7% $20

2.0 3.2% $20 $1000

(a) What is the bond’s theoretical price?

(b) What is the bond’s yield?

20×e-0.02×0.5+20×e-0.023×1+20×e-0.027×1.5+1020×e-0.032×2 = 1015.32

The bond’s yield assuming that it sells for its theoretical price is obtained by solving

20×e-y×0.5+20×e-y×1+20×e-y×1.5+1020×e-y×2 = 1015.32

It is 3.18%.

A five-year bond provides a coupon of 5% per annum payable semiannually. Its price is 104.

What is the bond's yield? You may find Excel's Solver useful.

Suppose that 3-month, 6-month, 12-month, 2-year, and 3-year OIS rates are 2.0%, 2.5%,

3.2%, 4.5%, and 5%, respectively. The 3-month, 6-month and 12-month OISs involve a single

exchange at maturity; the 2-year and 3-year OISs involve quarterly exchanges. The

compounding frequencies used for expressing the rates correspond to the frequency of

exchanges. Calculate the OIS zero rates using continuous compounding. Interpolate linearly

between continuously compounded rates to determine rates between 6 months and 12

months, between 12 months and 2 years, and between 2 years and 3 years. You may find

Excel’s Solver useful.

The calculations are indicated on the Excel file. The 3-month, 6-month, 12-month, 2-year and

3-year zero rates are 1.9950%, 2.4845%, 3.1499%, 4.5153%, and 5.0264%, respectively.

Problem 4.27

An interest rate is quoted as 5% per annum with semiannual compounding. What is the

equivalent rate with (a) annual compounding, (b) monthly compounding, and (c) continuous

compounding.

b) With monthly compounding the rate is 12 �(1.0251/ 6 - 1) = 0.04949 or 4.949%.

c) With continuous compounding the rate is 2 �ln1.025 = 0.04939 or 4.939%.

Problem 4.28.

The 6-month, 12-month. 18-month,and 24-month risk-free zero rates are 4%, 4.5%, 4.75%,

and 5% with semiannual compounding.

a) What are the rates with continuous compounding?

b) What is the forward rate for the six-month period beginning in 18 months

c) What is two-year par yield

The 12-month rate is 2ln1.0225 = 0.044501 or 4.4501%. The 18-month rate is

2ln1.02375 = 0.046945 or 4.6945%. The 24-month rate is 2 ln1.025 = 0.049385 or

4.9385%.

b) The forward rate (expressed with continuous compounding) is from equation (4.5)

4.9385 �2 - 4.6945 �1.5

0.5

or 5.6707%. When expressed with semiannual compounding this is

2(e0.056707�0.5 - 1) = 0.057518 or 5.7518%.

c) The value, A of an annuity paying off $1 every six months is

e -0.039605�0.5 + e-0.044501�1 + e -0.046945�1.5 + e -0.049385�2 = 3.7748

The present value of $1 received in two years, d , is e -0.049385�2 = 0.90595 . From the

formula in Section 4.6 the par yield is

(100 - 100 �0.90595) �2

= 4.983

3.7748

or 4.983%.

Problem 4.29.

Suppose that the risk-free rates are as in Problem 4.28. What is the value of an FRA where

the holder pays LIBOR and receives 7% (semiannually compounded) for a six-month period

beginning in 18 months. The current forward LIBOR rate for the period is 6% (semiannually

compounded).

0.5 �(0.07 - 0.06) �$10, 000, 000 /1.0254 = $45, 297.53

Problem 4.30.

The following table gives the prices of Treasury bonds

Bond Principal ($) Time to Maturity (yrs) Annual Coupon ($)* Bond Price ($)

100 0.5 0.0 98

100 1.0 0.0 95

100 1.5 6.2 101

100 2.0 8.0 104

months.

b) What are the forward rates for the periods: 6 months to 12 months, 12 months to 18

months, 18 months to 24 months?

c) What are the 6-month, 12-month, 18-month, and 24-month par yields for bonds that

provide semiannual coupon payments?

d) Estimate the price and yield of a two-year bond providing a semiannual coupon of

7% per annum.

a) The zero rate for a maturity of six months, expressed with continuous compounding is

2 ln(1 + 2 / 98) = 4.0405% . The zero rate for a maturity of one year, expressed with

continuous compounding is ln(1 + 5 / 95) = 5.1293 . The 1.5-year rate is R where

3.1e -0.040405�0.5 + 3.1e-0.051293�1 + 103.1e- R�1.5 = 101

The solution to this equation is R = 0.054429 . The 2.0-year rate is R where

4e -0.040405�0.5 + 4e -0.051293�1 + 4e -0.054429�1.5 + 104e - R�2 = 104

The solution to this equation is R = 0.058085 . These results are shown in the table

below

(%)

0.5 4.0405 4.0405 4.0816

1.0 5.1293 6.2181 5.1813

1.5 5.4429 6.0700 5.4986

2.0 5.8085 6.9054 5.8620

b) The continuously compounded forward rates calculated using equation (4.5) are

shown in the third column of the table

c) The par yield can be calculated from the formula in Section 4.6. It is shown in the

fourth column of the table.

3.5e-0.040405�0.5 + 3.5e-0.051293�1 + 3.5e-0.054429�1.5 + 103.5e-0.058085�2 = 102.13

The yield on the bond, y satisfies

3.5e - y�0.5 + 3.5e- y�1.0 + 3.5e- y�1.5 + 103.5e- y�2.0 = 102.13

The solution to this equation is y = 0.057723 . The bond yield is therefore 5.7723%.

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